Good-bye Profit Margin
Acme Sheet Metal has bid to install the air-handling system for a major building renovation. Its estimator has reviewed and bid off of a set of plans and specifications prepared by the owner’s architect and mechanical engineer. Acme has signed a subcontract form prepared by the general contractor with a "not to exceed" price. The subcontractor orders its materials, schedules its work force, and starts the job.
Thirty days into the project, the job superintendent for the General Contractor informs Acme’s on-site representative that problems have been discovered with the air-handling system design. Acme will be required to replace some of the completed work, fabricate some unconventional duct work for certain areas, and install additional ducts and diffusers. A question has also arisen as to responsibility for fireproofing of wall penetrations required for the duct work. It is not clear on the original specifications whether the work was within Acme’s scope. The subcontract language refers to the specifications and "all work normally undertaken by those in the trade for this type of project." The superintendent insists that the fireproofing falls under that language.
The project is already behind schedule and the job superintendent demands that Acme start immediately on the necessary work. He assures the subcontractor that any cost issues will be addressed fairly once the immediate crisis has passed. Acme proceeds on the basis of some marked-up plans and a verbal authorization to do the work.
The next month, the subcontractor submits its application for payment and includes line items for labor, materials, overhead, and profit on the new work. Acme also includes a line item for the fireproofing work on the wall penetrations. The architect refuses to approve the costs for the new work and fireproofing and threatens not to process the payment request, unless Acme sets those items aside for a later resolution. Needing the rest of its progress payment, Acme ends up negotiating to a discounted price on the extra work and recovers nothing for overhead and profit. Acme also ends up absorbing most of the cost of the fireproofing work. A job that initially had a reasonable profit margin has suddenly become unprofitable.
This is somewhat of a "worst case" scenario. However, changes in the scope of work pose a risk for the subcontractor. There is likely to be time pressure to get the changes implemented. Attempts to get a written agreement on the change may be brushed aside. Simply getting the work done can be so all consuming that recordkeeping can get sloppy. The labor and materials costs for the changed work can get mixed in with the figures for the original work. It is easy, and tempting, for a subcontractor to do exactly the wrong thing when faced with a change in the work. To maintain the profitability of a job, the subcontractor and its staff must take a disciplined approach and insist that changes in the work be handled with specificity and fairness.
Change Order Terms
When contractors discuss changes in the work, the term "change order" is most commonly used. However, changes in the work can be carried out through a number of different mechanisms. A general contractor may simply instruct the subcontractors to take an action without anything in writing. This is sometimes referred to as a "field directive." The general contractor may deliver a written description of a change and demand that it be implemented, even though there is no price or mechanism for determining the price agreed upon. This is sometimes called a "construction change directive." Finally, the change may be set out in writing with an agreed-upon price or method of determining the price and is signed by both parties. This is a "change order," which constitutes a legal amendment to the subcontract.
Change Order Pricing
Subcontract forms can vary widely on how they deal with change order authorizations and pricing. The most common subcontract forms require that the general contractor specify a price in the change order or directive. The subcontractor will typically not be paid for any changes performed by the subcontractor that have not been ordered by the general contractor.
Most subcontract forms handle the adjustments to contract price using all or some combination of the following four methods:
1. A mutually agreed lump sum, 2. Unit prices (which are often specified in the subcontract); 3. An agreed fee plus cost; or 4. The cost to the subcontractor of labor (including benefits), materials, supplies and equipment, insurance, permits, and taxes.
In reviewing a proposed subcontract form the pricing for change orders should be evaluated. Some subcontracts provide that price adjustments will be made under the subcontract only to the extent that the general contractor can obtain an equivalent adjustment from the owner. If multiple subcontractors are involved in the change, the subcontract may state that the subcontractor will take a proportionate “haircut” with the other subcontractors, if full reimbursement is not available for all the work. The subcontract may permit the architect to hold up all payment for changes in the work, if disputes exist as to pricing. Most subcontract forms require the subcontractor to respond in writing to the price adjustment proposed by the general contractor and failure to object could be deemed an acceptance of the price.
The new AGC/ASA/ASC Standard Form Construction Subcontract addresses these issues. The form specifies that change-order pricing will occur using one of the first three methods described above or as otherwise agreed by the parties. The subcontractor is required to notify the contractor if it disagrees with proposed price adjustments. If the subcontractor disagrees or does not respond, the contractor will determine the appropriate adjustment. The adjustment is to include a reasonable mark-up for overhead and profit. If the subcontractor disagrees with the contractor’s determination, the subcontractor can demand mediation and arbitration. The subcontractor is to receive payment for all undisputed amounts. Having a reasonable subcontract, like the new Standard Form, with fair pricing and payment provisions, is one key step in avoiding change-order disputes.
Faced with a material change in the scope of its work, a subcontractor should also strongly consider the following:
1. Obtain as much detail as possible concerning the requested change and get it in writing. Do not hesitate to seek written clarification of questioned items in a change order or a construction change directive. The subcontractor will not get paid for work that is not ordered.
2. If the general contractor will not provide an acceptable level of detail and the subcontractor has to proceed with the work, the subcontractor should send its own written description of what work it will perform in response to the change order or construction change directive.
3. Try very hard to work out the price before the work commences and, if that cannot be done, agree in writing upon the mechanism for the price adjustment. Make sure that the mechanism includes a proper accounting for overhead and profit and costs arising out of adjustments to the work schedule. If some work lends itself to a unit pricing approach, those unit prices can easily be set out in the subcontract, eliminating later pricing issues.
4. If a directive or change order raises issues about the scope of the work covered under the original subcontract, try to get those issues clarified before you start work under the directive or change order. Your acceptance of the change could later be used against you.
5. Keep accurate labor, materials and time records for the change order and construction change directive work (unless you have agreed to a Lump sum payment). It is never recommended that a subcontractor proceed on a field directive for any significant item of work.
6. Within reason, document everything. Disputes over change orders inevitably come down to arguments over who said what to whom. Memories fade (sometimes conveniently) and history can be rewritten. However, documents, memoranda, and records made at the time are a strong indication of what parties truly intended.
The careful subcontractor would do well to approach significant changes in its work with an eye on its contract, a hand on its wallet, and a healthy suspicion of assurances that "we will work it out later." Work out the details and price, get it in writing, and then start the work. You won’t regret it.